Don't ignore duration risk, investors warned

Fixed income investors should be mindful of the effect that rising interest rates will have on long-dated bond portfolios, says Aviva Investors.

Speaking to InvestorDaily, Aviva Investors London fixed income senior portfolio manager James McAlevey said there is a general lack of understanding about duration risk across the market.

“Duration risk is effectively the sensitivity of a bond to the movement in interest rates,” he said.

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The low-interest rate environment of the past three to four years has seen companies issue more long-duration bonds, he added.

“[Companies are] deciding not to issue two- to three-year bonds – they're deciding to issue 20-year bonds, 30-year bonds, even 50-year bonds and, in some instances, 100-year bonds. The longer maturity bonds you issue, the bigger duration is and the more interest rate risk you have attached to it,”Mr McAlevey said

“And that comes with potential downsides that I think many people are not engaged with, and many people are perhaps not as understanding of.”

Mr McAlevey said that while he didn’t intend to be ‘alarmist’, investors needed to assess both risk and return, not just return.

“Today that risk side of the equation is more important, investors should be evaluating that aspect of that asset class in a way that they haven't evaluated previously, and there are, after all, many, many ways for us to try and mitigate this,” he said.

Pointing to the US Treasury as an example of something often defensive in nature that performed well during global flight to quality or market crashes, he said Aviva Investors were looking at strategies “relatively derivative-intensive” in nature.

Mr McAlevey also said, in repositioning portfolios, other options would be to use inflation-linked securities; having “low duration as opposed to long duration”; engage with ‘relative value strategies’; and buy and sell interest rate markets.

Aviva Investors Australian head of institutional business development Brett Jackson said mitigating risks also involved being more selective about investments made in government or corporate securities.

“Instead of buying [a] whole bucket of securities, or group of securities, we’ll get quite specific about what type of securities we want, [and] what duration: are they 10-year bonds, eight-year bonds, five-year bonds?” Mr Jackson said.

“Also, [with] corporate securities: we’re loaning money to the likes of Coca Cola, Disney, etc. It’s what type of security, how much risk we’re taking with that corporate, and what protections we have on the money we loan.”

Mr McAlevey said retail investors, in particular, seemed to misunderstand the role of bonds in portfolios and stressed the need for further education in this area.

“Several years ago in the US, there was a survey of retail investors,” he said. “And that survey asked retail investors: what happens to the value of your bond funds when interest rates go up?

“I think about 70, 75 per cent of those retail investors thought the value of their bond fund went up when interest rates went up.

“And I think this is just indicative of the lack of understanding that exists within the asset class, particularly amongst the retail type investors, who are perhaps buying this asset class diverse for the wrong reasons.”